The problem with the Value-Added Tax

Widely used in Europe, the Value-Added Tax (VAT) has always seemed a non-starter in the United States. That may be changing given apparently insurmountable structural deficits and fear that the financial collapse of Greece could happen here if revenue isn’t increased. These days, the VAT is being taken seriously even by pro-market conservatives and libertarians. A VAT is a consumption tax which is levied at each stage of production based on the value added to the product at that stage.

Harvard economist Gregory Mankiw, the former chairman of George W. Bush’s Council of Economic Advisors, recently wrote in favor of a VAT if part of the revenue was dedicated to deficit reduction. If it’s true that the level of spending cuts needed to shrink deficits are politically unrealistic, explains Mankiw, then “a VAT is…the best of a bunch of bad alternatives. Conservatives…should be willing to swallow a VAT as long as they get enough other things from the deal.” For Mankiw, the “other things” are primarily deficit reduction.

My Mercatus Center and George Mason University colleague, the free-market economist Tyler Cowen, while not endorsing the VAT recently wondered at which point of our financial troubles would we consider it. “What if government default were a week away and there wasn’t enough short-term spending to cut,” he wrote. “Would you consider a VAT then? I hope so. How far back toward the present will you go in considering a VAT?”

The VAT started in France in 1956. Today, it has spread to most European countries, as well as countries such as Australia, New Zealand, and India. It is a tax on the transfer of goods and services that ultimately is borne by the consumer. As such, it increases the cost of just about everything, from your bread and cheese to a visit to the hair salon. Because it taxes consumption rather than income it is a better tax than an income tax that penalizes savings and investment. It is also a fantastic revenue-raising machine. For a sense of just how efficient the VAT is at squeezing revenue out of everyone and everything, Fortune offers an example of how the VAT could figure into the purchase of a car.

Liberals and big-government enthusiasts like the VAT precisely because it’s so ubiquitous (and because it’s typically layered on top of existing taxes, rather than being substituted for them). For pro-market foks, the VAT is appealing only if its funds are mostly used for deficit reduction and, hence, avoiding a Greek-style collapse brought on by unsustainably large public-sector debt. Cowen, for instance, asks if maybe “there exists a credible bipartisan deal which involves at least half the VAT revenue for deficit reduction, combined with cuts, or slower increases, in marginal tax rates on income and perhaps an elimination of the corporate income tax.”

The first thing to note is that Greece collapsed in spite of having a 19 percent VAT since 2005. The second thing is that there’s little to no chance that the government could credibly commit to assign even a share of any new VAT revenue to deficit reduction. Take President Obama’s first budget, released last year. In it, he assumed that most of the $600 billion coming from proposed cap-and-trade fees would be allocated to deficit reduction. A year later, his budget still assumes the revenue (even though the law is not yet passed), but all of it has been allocated to spending programs, not to reducing the deficit. A government that cannot commit fictional revenue to deficit reduction is unlikely to do so with actual money either.

There’s more. Even if the government could credibly pledge VAT revenue to deficit reduction, a VAT would not even start to address our problems. Projections by the Tax Policy Center show that a 5 percent VAT in the U.S. would raise over $3 trillion in the next 10 years. However, using Office of Management and Budget data, we can see that in the next decade, we would need an additional $5.8 trillion in revenue to fill the gap.

Even a 10 percent VAT-the rate that Ezekiel Emanuel, the brother of White House chief of staff Rahm Emanuel and a health-care adviser to White House Budget Director Peter Orszag, argues would pay for every American not entitled to Medicare or Medicaid to enroll in a health plan with no deductibles and minimal copayments-wouldn’t be enough to cover our short-term deficits.

And our real financial troubles only kick in after that period, when baby boomers will start retiring and Medicare costs will explode (see the chart here). The VAT doesn’t start to cover this spending explosion, though it could introduce perverse incentives to the labor market. As economist Arnold Kling explains at EconLog: “Given all of our other taxes, I doubt that a VAT would raise enough money at the margin to make a difference. Already, marginal tax rates are very high for several classes of people, particularly those with low enough incomes to qualify for various means-tested government programs. Introduce a significant VAT on top of the current tax system, and lots of people are going to decide that housework and the underground economy are more lucrative than working in the market.”

Beyond questions of how much revenue it might generate, the presumption underlying the push for a VAT by pro-market economists is that the government can’t effectively cut spending or reform entitlements. While this position has a compelling amount of historical evidence in its favor, I don’t think this is true.

Obviously, the amount of spending cuts required to meet our upcoming fiscal crisis is exponentially bigger than what most countries have managed to trim in the past. Even if the small spending cuts that were achieved in the 1990s were somehow reproduced, they would not put a dent in our debt. But VAT proponents who claim that we can’t cut spending enough or reform entitlements underestimate the fact that the massive redistribution of income from the young to the old will soon become politically unsustainable. Everyone simply assumes that younger generations won’t be willing or able to take dramatic measures to force a change to the status quo.

Yet a 2008 Winston Group survey showed that 56 percent of voters believe the free market is a better way to solve problems than expanded government programs. Of the 18-25 year old group, 36 percent believed that the best way to increase economic growth and create jobs is to cut taxes (26 percent disagreed). Back in 2004 during George W. Bush’s abortive attempt to reform entitlements, 74 percent of 18-25 year olds favored Social Security privatization.

This support for markets surely has to do with the fact that few younger voters believe that they will receive much from the government when they retire. In July 2009, a Zogby poll found that only 18 percent of voters in the 18-29 age range think they will ever see Social Security checks one day. This same poll found that only 39 percent of voters in this age range thought that Medicare would be there for them, and a mere 20 percent thought that it would be there for their children.

If younger voters are increasingly skeptical of Social Security and Medicare, they are increasingly committed to taking their views to the polls. If that’s the case, and they elect lawmakers who represent their views on entitlements, things could change fast. In 2004, 20.1 million people in the 18-29 year old range voted, a 4.3 million increase over the turnout in 2000. In the 2006 midterm elections, turnout in the same range grew by nearly 2 million voters over the turnout in 2002. Young voters doubled the number of votes they cast in 2008 compared to 2004. And the raw number of young voters is fast challenging the senior vote. According to the Census Bureau, the size of the 18-29 year old electorate in 2004 (20.1 million voters) rivaled that of the much-coveted senior vote (22.3 million voters over 65). (For a discussion of the youth vote, go here and here.) Unless we believe that younger voters will sit on their hands while their future payouts are slashed and their taxes are hiked to pay for the benefits of current retirees, then entitlements will have to be reformed and spending will be cut.

Which suggests a final thought: Focusing on revenue mechanisms such as a VAT in deficit-reduction discussions misses the point that spending and revenue tend to be very loosely correlated. Governments spend when don’t have revenue and they spend when they do have revenue. The danger of the VAT is not that it will grow and grow or that it will cripple an economy. For much of the 1990s, many countries, including the United States, managed to reduce their share of spending as a percentage of GDP. Many of those with VATs even cut their rates on that particular tax. Yet VATs and higher levels of public spending more generally mess with long-term economic growth. Looking for new sources of revenue moves our attention from what can and should be done now: slow or stop spending increases and reform entitlements, sooner rather than later.

Certainly, it is not the time to embrace bad tax policy in the name of fatalism.